What is an ETF?

ETFs, or exchange traded funds, have caught the attention of many traders over the past 10 years.  These trading vehicles provide investors with the ability to diversify their assets within multiple asset classes, similar to mutual funds.  However, unlike mutual funds, they provide the same features that a stock would.  You can trade them on the major exchanges and place limit orders and even sell these securities short.

The index etf was the first type of ETFs to hit the market.  They tracked broad market indices, such as the S&P 500, Dow Jones Industrials, & even the Nasdaq 100 technology index. However; in recent years, the number of exchange traded funds hitting the market has grown substantially as investors demand more granular diversification options.  ETFs allow you to invest in a slice of the marketplace; for example, the GDX gold etf replicates the performance of the NYSE Arca gold miners index while the XLF is a financial etf which replicates the performance the S&P 500 financial select sector.

To provide even more flexibility, ETFs can now be traded to track overseas markets, fixed income products, and even baskets of random stocks.  Furthermore, short etf instruments are now available to capture the downside of a sector.  These inverse etfs are especially handy to IRA investors who can only go long securities.  Finally, the idea of leverage has permeated its way into the ETF market; there are a handful of double and triple leveraged etf funds which allow speculators to, in effect, use margin without actually doing so.

Advantages of ETFs versus Mutual Funds

ETFs offer a few distinct advantages over mutual funds. Day traders especially are thrilled with the ETF product as it allows them to trade indices intra-day, just as they would another stock, without the high management fees, short term trading fees, or minimum investment amounts that mutual funds require. For example, did you ever want to buy the S&P 500 or the DOW Jones to take advantage of the intra-day swings in the market? In the past, this was not possible as these indices were only available to purchase through mutual funds, which are priced nightly. Exchange traded funds offer that capability. They allow you to buy an index such as the S&P500 through an ETF security on the stock exchange. The S&P 500 can be bought through trading the ticker symbol SPY.

Take Advantage of Market Volatility

Many of you are now taking your financial responsibility into your own hands and getting more involved in your own financial decisions rather than leaving it to others to manage. From my experience, the single biggest advantage of ETFs is that they allow you to take advantage of extreme market volatility. For example, there have been times when the DOW Jones has dropped nearly 300 to 500 points intra-day only to bounce back and close up. A mutual fund wouldn't allow you take part in that reversal which may have seemed obvious to some. However, one could buy an ETF in the face of this capitulation. Again, this requires a more advanced trader to know when it is the right time but the opportunity is there nonetheless.

Lower Expense Ratios

When comparing the ETF fee structure against that of mutual funds, there is no comparison. On average, mutual funds have an expense ratio of about 100 basis points. Now, let's take a look at the expense ratios of a few popular large index etfs. The DIA (Dow Jones ETF) trades with a 17 basis point expense ratio, the SPY (S&P500 SPDR) trades with a 9 basis point expense ratio, and finally, the QQQQ ( NASDAQ 100 Power Shares) trades with a 20 basis point expense ratio. These numbers may appear small to you but can add up exponentially over time if you have a long term view in holding this security.

Tax Loss Strategies using ETFs

You can use ETFs to help you take a tax loss on a stock that you are down for on the year. At the end of the year for example, if you have a $10,000 loss on shares of Merck, you could sell Merck and purchase a pharmaceutical ETF. This will allow you to take the tax write-off for the loss but also take advantage of the possible appreciation of that stock during the 31 day "wash sale" period in which you are not allowed to buy Merck back. This strategy will not be very possible with mutual funds as many of them incur short term trading fees if you hold them for less than a certain amount of time.

For larger portfolio's especially, ETFs offer better tax management abilities than mutual funds and can translate into considerable tax savings. As we discussed above, exchange traded funds are traded just like stocks within a brokerage account. Therefore, you will have the ability to identify tax lots for sale. What does this mean? Well, it will enable you to sell your ETFs, which have the highest cost basis, minimizing your capital gain for the year.

Mutual funds on the contrary work off of average cost price only; thereby reducing your ability to realize tax losses.

Shorting ETFs

For those traders who enjoy trading the swings in the stock market or even want to hedge against long positions, ETFs offer you the ability to short them. For those of you not familiar with shorting, the basic idea is to profit from the stock price falling. I would not recommend inexperienced traders attempt to do this.  Being short can offer fast gains but can result is large losses just as quick.  This is especially useful for exchange traded funds which do not have an inverse counterpart.

This would have been especially useful during the bear market of 2000 to 2003, where the stock markets lost anywhere from 50% to 80% of their value. As a hedge, one could have shorted an ETF to offset losses in their portfolios.

Disadvantages of ETFs versus Mutual Funds

Let's review some of the key disadvantages of an ETF when compared to a mutual fund so that you can accurately decide whether ETFs or Mutual Funds are the right way to go for you.

Brokerage Fees

Brokerage fees can hurt your return in an ETF when comparing it to a similar mutual fund under certain conditions. If you are investing in an AIP, or automatic investment plan through a broker where you invest multiple times in a month, the trading fees will rack up faster than you can blink and this will undoubtedly hurt your returns over the years especially if you invest in small amounts. However, if you are a long term investor buying more than a couple shares, it will be quite advantageous to buy an ETF in the long run.

Valuation is not directly correlated with the net asset value of the ETF
Another small setback, in my opinion, of an ETF is that they do not trade at their Net Asset Value (NAV) as Mutual Funds do. Since they are traded as stocks on the exchanges, supply and demand forces drive ETFs up and down, above and below the true value of the underlying assets.

No Dividend Re-Investment Plans.

While most mutual funds offer dividend re-investment plans, ETFs generally do not allow this.

Where can I research ETFs?

The introduction of new ETFs into the marketplace has been exponential over the past few years and it may be hard to locate the one for you. To help with that process, I have found these research sites useful for investigating ETFs:

Wall Street Journal ETF Research
Morning Star ETF Research
Yahoo ETF Research

Part 2:  Leveraged ETFs
Part 3:  ETF Discounts and Premiums
Part 4:  Actively Managed ETFs
Tim Ord
Ord Oracle

Tim Ord is a technical analyst and expert in the theories of chart analysis using price, volume, and a host of proprietary indicators as a guide...
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